(The Bond Vigilantes are
dead - RIP - Long Live the Sultans of Swap)
Every parent has had that
moment when their child asks them the simplest sounding question but in that
instance before you respond, you realize you have never really thought about
it and actually don"t know the real truth. To not have an answer would
be to lose all credibility as the "all knowing" parent. Like
generations of parents before you - you bluff!
When asked
why there are $605 Trillion derivatives outstanding (1) how do you articulate
an answer to this horrendous and almost unimaginable number? The US is the
largest economy in the world but tallies only 2.3% in comparison. Global bank
reserves amount to only 1.2% of this accumulation. The gargantuan size
appears to defy all logic.
Before some of you experts out
there accuse me of sensationalism let me quickly give you the response of the
"all knowing" to knock this number down to something that is
intended to allow you to once again sleep at night.
First $605 is the notional value. This
number according to experts (2) is best used simply to get an indication of
how rapidly the overall derivatives market is growing (wow) since it
doesn"t represent the value of what is at stake to the parties engaged
in the transaction. It double counts positions, doesn"t represent what
changes hands and doesn"t discount hedges that offset each other. What
we need to consider is settlement amounts if all the contracts had to be
settled today for some unknown reason (i.e. a 1930"s bank holiday
crisis?). Our number then drops to just over $25T. That sounds better but
still is a staggering figure considering the assets of the US are estimated
to be $56T and is 1/3 of global assets (3). Not to be deterred our "all
knowing" experts would then assuredly point out that actually the number
is a mere $3.7T when all the contracts directly offsetting each other are
netted. Appeased, our cocktail chatter would resume in a much more subdued
tone. Or should it?
I have been thinking about the
truth regarding this imponderable for a few years now. I have likewise
successfully answered the question at numerous polite social gatherings but
never felt comfortable with my response. My credibility intact I would scold
myself to delve more thoroughly.
Eureka!
While authoring my recent
article 8 Fault Lines
in the Euro Experiment which was prompted by the debacle in Greece, I
found myself like Archimedes the Greek before me, shouting Eureka - I have
alas found it! But before I share the "all knowing truth" with you
I must caution those with weak hearts and small children: parental guidance
is advised!
8 YEARS OF PAIN
In 2007 I authored another
paper entitled "8 Years of Pain". It called for a US housing
collapse and a resulting derivatives implosion. We sort of got the score
right but the lyrics were wrong. Similar to the Titanic, we knew Icebergs
were out there but we didn"t have the required instruments needed to
identify it clearly with sufficient precision. In hindsight we now realize it
was because we still weren"t aware of exactly how banks were using
SIV"s (Structured Investment Vehicles) to sell CDOs and protect
themselves with CDSs. The mechanics of how Toxic instruments were actually
being created wasn"t readily available in the public domain. These
instruments had yet to have the media spotlight shown on them as they lurked
quietly through dark waters. We knew of SPE"s (Special Purpose
Entities) from the Enron debacle, so we suspected something similar but
we could only speculate. The puzzle we had was that $437T of the $605T of the
notional value of derivatives outstanding were Interest Rate Contracts and
$342T of these were specifically Interest Rate Swaps with a Gross Market
Value of $13.9T. Calculations indicated there was insufficient cross border
corporate and financial sector needs for this level of exchange - by orders
of magnitude.
EURO EXPERIMENT
The Enron debacle and the
Financial Crisis taught me to dig deeper (and fast!) when I suspect
the Wall Street Merlins have been insidiously concocting their magical brews.
As the Greek crisis was unfolding, by happenstance I discovered SPC
(Special Purpose Company) and PPI/PFI"s. I also discovered
the SPC
Titlos PLC which I outlined in 8 Fault Lines in the
Euro Experiment. I realized;
Massive Monetary Money
is being created through Interest/Currency Rate Swap Derivatives
In our modern monetary fractional
banking system money can only be borrowed into existence. It can only be
created through the act of lending. By facilitating the ability to lend,
money can and is created. It takes three elements for this to occur:
1) A lender with the ability to lend,
2) A borrower with a need and
3) The same borrower with sufficient collateral to actually secure the loan.
ACCOUNTING STANDARDS - Corporate, Financial & Public
Almost all Sovereign
Treasuries have the continuous lust for borrowing and historically almost
unlimited public assets to pledge as collateral. The problem is neither the
need nor collateral. The problem is public perception as viewed through the
optic lenses of public sector accounting standards. Circumvent the
restrictive public accounting standards and Eureka - we have a lender. Like
Enron it was about circumventing private sector accounting standards
through off balance sheet SPE"s. In the financial crisis we found it was
the banks circumventing banking capital accounting standards by off balance
sheet SIV"s. In both instances it is motivated by the advantage of
removing obligations from the reported asset / liability ledger.
This is precisely the brew the
great Merlins - like Goldman Sachs have delivered to Sovereign powers as the
magic elixir for public accounting standards. Our political leaders
like Enron executives and bank executives before them have become drunkards
on the magic elixir. It gives politicians (the ultimate alcoholics)
the power to take on more debt without impacting the traditional metrics
which increase borrowing costs.
THE MAGIC
"BREW"
Like the song "Love
Potion #9" - "let"s mix some up right here in the sink".
Securitization is about
turning revenue streams or "receivables" from time dependent assets
into securities. Whether it is accounts receivables through ABSs (Asset
Backed Securities) or mortgages through MBS"s (Mortgage backed
Securities) the basic concept does not change. Securitization requires a
future payment stream (scheme) that can be secured and has a securing
collateral value. It didn"t take creators long to understand that
corporations had only so much receivables and there was only so many
mortgages that could be sold.
The Holy Grail of
Securitization is Sovereign Government
with their tax revenue streams and huge public collateral assets
Like modern alchemists the
secret is how to turn it into gold. Let"s get started:
Stage I - CREATING THE
BORROWER
1 You take a sovereign
Government that needs money but is restricted from lending further.
2 You then create a PPP:
Public Private Partnership as the mechanism for involving the private
business sector in public sector projects.
3- You also create an SPC
(Special Purpose Company) that will represent the private sector business
sector interest.
4- You further create a PFI:
Private Finance Initiative in which the public and private sectors join. They
join (some might use the incorrect terminology: to collude but this is
incorrect since all this is still legal) to design, build or refurbish,
finance and operate (DBFO) new or improved facilities and services to the
general public.
5- "You then typically,
through the Special Purpose Company (SPC), hold a DBFO contract for
facilities such as hospitals, schools, and roads according to specifications
provided by public sector departments. Over a typical period of 25-30 years,
the private sector provider is paid an agreed monthly (or unitary) fee by the
relevant public body (such as a Local Council or a Health Trust) for the use
of the asset(s), which at that time is owned by the PFI provider. This and
other income enables the repayment of the senior debt over the concession
length. (Senior debt is the major source of funding, typically 90% of the
required capital, provided by banks or bond finance). Asset ownership usually
returns to the public body at the end of the concession. In this manner,
improvements to public services can be made without upfront public sector
funds; and while under contract, the risks associated with such huge capital
commitments are shared between parties, allocated appropriately to those best
able to manage each one" (4)
6- So far we have established
something similar to a "reverse mortgage". As every financial
advisor knows, reverse mortgages hide truly significant financing costs from
the unsuspecting or desperate. The banks" Reverse Mortgages prey on the
elderly the same as the SPC-PPI/PFI preys on the hapless political apparatus
desperate for unpublicized solutions to their prolific spending and
irresponsible election promises. With campaigning never ending and governing
never beginning, the politicians of today no longer step up to the unpopular
choices required of sound fiscal policy.
Stage II - CREATING THE
LENDER
The next step is a
little trickier. You need to pay particular attention as we move from the
counter mixing area for our "love potion" to the sorcerer"s
boiling pot. We have solved the two elements associated with the borrower but
the real trick is solving the lenders ability to continue to lend the absolute
amounts of money these high powered brews deliver.
7- The next step is to add the
secret ingredient. It is a combination of the old reliable SPV (Special
Purpose Entity) but in this instance specifically called a Swap Agreement
Securitization SPV (i.e. Titlos
PLC). With it you add a hardening catalyst called the NOVATION AGREEMENT.
You then let the brew simmer ensuring it is available when the central banks
says they are ready for a serving.
DEFINITIONS:
Let"s define some of our
ingredients.
NOVATION AGREEMENT - From Wikipedia
Novation is a term used in contract law and business law to describe
the act of either replacing an obligation to perform with a new obligation,
or replacing a party to an agreement with a new party. In contrast to an assignment, which is
valid so long as the obligee (person receiving the benefit of the bargain) is
given notice, a novation is valid only with the consent of all parties to the
original agreement: the obligee must consent to the replacement of the
original obligor with the new obligor.[1] A contract
transferred by the novation process transfers all duties and obligations from
the original obligor to the new obligor.
For example, if there exists a
contract where Dan will give a TV to Alex, and another contract where Alex
will give a TV to Becky, then, it is possible to novate both contracts and
replace them with a single contract wherein Dan agrees to give a TV to Becky.
Contrary to assignment, novation requires the consent of all parties. Consideration is still
required for the new contract, but it is usually assumed to be the discharge
of the former contract.
The criteria for novation
comprise the obligee's acceptance of the new obligor, the new obligor's
acceptance of the liability, and the old obligor's acceptance of the new
contract as full performance of the old contract.[
Novation is also used in futures/options
trading markets to describe a special situation where the clearing house
interposes between buyers and sellers as a legal counter party, i.e., the
clearing house becomes buyer to every seller and vice versa. This obviates
the need for ascertaining credit-worthiness of each counter party and the
only credit risk that the participants face is the risk of clearing house
committing a default. Clearing House puts in place a sound risk-management
system to be able to discharge its role as a counter party to all
participants. The term is also used in markets that lack a centralized
clearing system (such as the swap market), where "novation" is used
to refer to the process where one party to a contract may assign its role to
another, who is described as "stepping into" the contract. This is
analogous to selling a futures contract. From Wikipedia
SPE - SPECIAL PURPOSE
ENTITY - From
International Swaps & Derivatives Association
CENTRAL BANK
"REPO" AGREEMENT
from Wikipedia
A Repurchase agreement
(also known as a repo or Sale and Repurchase Agreement) allows
a borrower to use a financial security
as collateral
for a cash loan at a fixed
rate of interest. In a
repo, the borrower agrees to sell immediately a security to a lender and also agrees to buy
the same security from the lender at a fixed price at some later date. A repo
is equivalent to a cash transaction combined with a forward contract.
The cash transaction results in transfer of money to the borrower in exchange
for legal transfer of the security to the lender, while the forward contract
ensures repayment of the loan to the lender and return of the collateral of
the borrower. The difference between the forward price and the spot price is the interest
on the loan while the settlement
date of the forward contract is the maturity date of the loan.
CURRENCY ISSUANCE from Wikipedia
Many central banks are
"banks" in the sense that they hold assets (foreign exchange, gold,
and other financial assets) and liabilities. A central bank's primary
liabilities are the currency outstanding, and these liabilities are backed by
the assets the bank owns.
Although central banks
generally hold government debt, in some countries the outstanding amount
of government debt is smaller than the amount the central bank may wish to
hold. In many countries, central banks may hold significant amounts of
foreign currency assets, rather than assets in their own national
currency, particularly when the national currency is fixed to other
currencies.
CENTRAL BANK STERILIZATION from Wikipedia
In the financial literature, a
term commonly used to refer to a central banks operations which mitigates the
two potentially undesirable effects of inbound capital (currency appreciation
and inflation) is sterilization. Depending on the source, sterilization
can mean the relatively straight forward re-cycling of inbound capital to
prevent currency appreciation and / or a wide range of measures to
check the inflationary impact of inbound capital. The classic way to
sterilize the inflationary effect of the extra money flowing into the
domestic base from the capital account is for the central bank to use Open market
operations where it sells bonds domestically, which soaks up cash that
would otherwise circulate around the home economy. However this can be
inefficient if it causes interest rates to rise and hence encourages even
more inbound flows. A variety of other measures are sometimes used.[4]
8- When the Central Bank
issues Repos the bank (in our example above - the National Bank of
Greece) then pledges the SPE assets as collateral. Presto, the bank has
high powered money which can lent out at fractional reserve leverage of
approximately 10 X leverage.
If you want even more precise
measurements and ingredients for this brew I refer you to:
Just
what is the real level of government debt in Europe? Credit Write-down
Is
Titlos PLC (Special Purpose Company) The Downgrade Catalyst Trigger Which
Will Destroy Greece? Zero Hedge
We have taken future tax streams
similar to "receivables" and turned them into securitization
products. The government gets upfront cash today along with tax streams going
to cover needed principle/interest payments. They face balloon payments in
the future. The real benefit to the banks is they get the full value of the
asset today which they can use as capital ratios along with ability to
fractional lend out 10 times the value of the deposit streams. The deposit
streams would be similar to the deposits you make from your payroll and then
spend. The banks float is increased and thereby its lending facility is
increased. PRESTO - Money is created into existence!
PPP"s are so broad based
that this is how Geithner proposed to get the Toxic waste off the public
books - business as usual.
ARCHIMEDES" AXIOM
This allows the International
Banks to effectively become mini Federal Reserves, lending money into
creation by being ready whenever ANY global central bank is ready to expand
their money supply. Like the US Mortgage bubble they can"t get enough
product.
SULTANS
OF SWAP
Why is everything hidden in
the murky depths called "special" - like SPE, SPV or
"Structured" - like SIV? The answer is to keep them off the balance
sheet. Why would you not want something on the balance sheet where investors
and interested parties could see what is happening? Obviously so you can
camouflage them from what is happening.
The reason is fundamentally
Credit Ratings. Keep your debts low and your credit ratings high and the cost
of money is cheap. The cheaper money is, the more borrowing will occur.
Everyone is happy except the unwitting lender.
It is here ladies and
gentlemen that we discover the Sultans of Swap. The Bond Vigilantes are of a
previous era. They are dead - RIP. Through the magic mix of Credit Default
Swaps, Dynamic Hedging and Interest Rate Swaps the Sultans of Swaps
effectively control interest rate spreads. Through Regulatory Arbitrage they
extort tremendous political sway globally. They live in the world of risk
free spreads. Low interest rates simply attract more volume for their
concoctions. We have had an explosion in Money Supply globally as the charts
(right) indicate. The parabolic rise matches the increase in these derivative
products along with their ability to turn Interest Rate Swaps into high
powered bank lending.
Like Achilles Heel in
Greek mythology, there is an exposure. Everything is based on tax payers
paying, GDP expanding and interest rates staying low. Titlos PLC shows severe
structured collateral calls when these assumptions change even modestly (5).
CASCADING COLLATERAL CALLS
With $3.7T in Gross Derivative
Credit Exposure outstanding, how many Greek Sovereign downgrades would it
take to begin cascading collateral calls? Don"t forget that we have
witnessed dramatic shortening of government "duration" over the
last few years. There are massive "rollovers" looming that will
further compound rates and their associated collateral requirements.
One final point, I need to be
really clear here. Nothing is actually hidden in all this. It is typically
there in the small type footnotes that are extremely difficult to interpret
or referenced to a document that is difficult to get your hands on. With
enough time and efforts you can get the facts. Also it is incorrect to
consider that the actions undertaken are to "evade" laws or
regulatory guidelines. They are done to avoid regulatory hurdles. I need to
differentiate this because it is what the lawyers always point out. I will
leave it to others why people might want to worry about the wording of what
are clearly material facts in such a manner.
As an investor it says to me
simply - Caveat Emptor in bold letters.
Like Archimedes the
Greek before me,
I discovered the answer in Greece - Eureka!
SOURCES:
(1) June 2009 Semiannual OTC derivatives
statistics at end-June 2009 BIS
(2) 10-15-08 $596 Trillion! How can
the derivatives market be worth more than the world's total financial assets?
Slate
(3) Jan 2008 McKinsey
& Company - Mapping Global Capital Markets: Fourth Annual Report -
Executive Summary - January 2008
(4) 02-14-10 Just
what is the real level of government debt in Europe? Credit Write-down
(5) 02-15-10 Is
Titlos PLC (Special Purpose Vehicle) The Downgrade Catalyst Trigger Which
Will Destroy Greece?
Zero Hedge
07-01-03 Revealed:
Goldman Sachs" mega-deal for Greece Risk.net
Feb 2001 SPV
Discussion Piece-FINAL-Feb 01 PDF International Swaps & Derivatives
Association
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